Top 10 ways to avoid a tax audit

"Worried about an IRS audit? Avoid what's called a red flag. That's something the IRS always looks for. For example, say you have some money left in your bank account after paying taxes. That's a red flag."
-- Jay Leno

While Leno might not have it exactly right, he is on to something: The IRS does look for red flags when selecting a return for audit. Their methodology, however, is a little more sophisticated than what the comedian suggests. While there's no foolproof way to escape an audit, here are some tips for keeping your return from being flagged:

1. Be good at math. The IRS continually cites bad math as one of the top errors on tax returns. Making math mistakes on your tax return will get you noticed -- and not in a good way. While the IRS will generally just correct your mistake and send you a bill, too many math errors might indicate a level of carelessness that causes your return to be flagged. So, use caution when preparing your return. Copy numbers onto forms or input into software carefully -- and double check those numbers when you're done. Check for transposition errors, as well as addition and subtraction. Don't have a false sense of security when using a software package. Your tax prep software can't tell when you've made a mistake before entering your data.

2. Don't be too rich. Statistically, you're about six times more likely to be audited if you report over $1 million in income than if you report income of less than $200,000. You're about three times more likely to be audited if you report between $200,000 and $1,000,000 than if you report income of less than $200,000.

Does the IRS have it out for the rich? Not necessarily. Those who make more money tend to take advantage of more itemized deductions, such as charitable contributions, which attract the attention of the IRS. Filing a Schedule A with significant charitable contributions or miscellaneous expenses may trigger an examination.

It's also highly likely that many higher income taxpayers are small business owners. Statistically, taxpayers who file a Schedule C are two to four times more likely to be audited. Many tax professionals recommend that taxpayers who are collecting substantial income from a small business consider incorporating in order to avoid filing a Schedule C that attracts attention.

3. Don't be too poor. While the upper class is generally the target of most audits, the other end of the spectrum isn't spared. When examining returns, the IRS is particularly interested in errors related to the Earned Income Tax Credit (EITC), a refundable credit that may only be claimed by lower income taxpayers. In 1999, the IRS reported $8.5 billion and $9.9 billion in over-payments related to the EITC. The error rate is about 30%, nearly three times higher than with other social programs.

Despite initiatives put in place to stamp out EITC errors and fraud, as recently as 2002, the IRS reported that it had issued math error notices on more than 1 million returns claiming $729 million in EITC. Common mistakes included amounts that were figured or entered incorrectly; missing or incorrect taxpayer ID numbers for qualified children; failure to report income; and dependent children who were ineligible for purposes of the credit.

If you qualify for the EITC, pay attention to the fine print. Report all your income; check and double check your math (see number one above).

4. Live within your means. Even if you're not too rich or too poor, make sure your tax return accurately reflects your economic reality. It doesn't make sense for you to report $30,000 in charitable donations on a $45,000 salary -- or home mortgage interest deductions of $10,000 for your $15,000 job. Think about the picture you're painting on your return: Does it make sense?

The IRS has a database, of sorts, of what it thinks it takes to survive based on where you live and the number of dependents you report. If your numbers are wildly different from those norms, it will question whether you are under reporting income or over reporting deductions. Just ask Rachel Porcaro, the Seattle mother of two boys, who was flagged for audit because the IRS did not understand how she could support her family on her salary.

The bottom line when it comes to reporting income and expenses: Your tax return shouldn't raise more questions than it answers.

5. Don't lose money. I've already alluded to the fact that filing a Schedule C may increase your risk of audit. This is because, according to a recent Government Accountability Office report, the IRS estimates that as many of 70% of taxpayers who report net losses on a Schedule C have artificially inflated expenses to create losses.

The IRS understands you will have years that are good and years that are not so good. But it likes to think you're in business to make a profit, even if you don't every single year. If, however, you're reporting losses on your Schedule C every year (especially for three or more years in a row), the IRS might question how you're managing to get by. Expect the agency to ask.

6. Remember that you're married (or not). Your marital status is determined as of December 31, 2009. It doesn't matter if you just got married (or divorced) on December 31 or if you've been married (or divorced) for the entire year. You may not file as single if you are still married -- even if you are living apart from your spouse. And you may not file as married filing jointly without the consent of your spouse. Don't file using the wrong marital status, and don't file without the proper number of signatures -- although it feels obvious, a joint return should have two signatures. Your spouse may forgive you if you forget that you're married, but the IRS won't.

7. Don't claim the wrong number of dependents and exemptions. You may claim a person as a dependent only if that person meets the legal definition of a dependent. Don't claim your cousin down the street just because you may send him or her a few dollars from time to time. If you're not sure who might qualify as a dependent, check out this prior post.

Adding or removing dependents from year to year without explanation could cause you to land on the IRS' radar screen. Similarly, claiming the same dependent as another taxpayer (which happens from time to time in the case of a divorce) may raise questions or cause your claims related to a dependent to be rejected, as will reporting the wrong Social Security number. If your dependent doesn't have a Social Security number but otherwise qualifies as your dependent, you'll need to get an ITIN for tax purposes.

8. Report all income. If you've ever used a software package to prepare your tax return, you should have noticed that the program constantly reminds you to enter the information on forms 1099, W-2, and the like exactly as it appears on the form. It's not just an annoying computer generated message -- there's a method to their madness. The IRS makes every effort to match nearly 100% of the forms submitted to them by employers and other organizations. Financial information reported by banks, brokerage houses, and other financial institutions are matched about 96% of the time. This makes your individual margin for error incredibly small. Take the time to collect all the forms sent to you by employers, banks and other organizations. If you fail to receive a form, follow up -- ask your employer where your form W-2 is, just in case it got lost in the mail. You don't want to overlook income that should have been reported on your return, especially when the IRS is so diligent about checking this one.

9. Learn to type. It may sound silly, but handwriting your return may slow down processing and result in a mistake that attracts the attention of the IRS. If the IRS cannot read your return, the return may be rejected. The IRS encourages you to e-file for just this reason; it claims the error rate on e-filed returns is reduced to 1% as compared to nearly 20% on a paper return. This, in the IRS' own words, "means a decreased likelihood of hearing from the IRS."

10. Be normal. You may have noticed a trend with respect to these tips: The IRS doesn't like returns that are different. In fact, it likes norms so much that it has a computer program to make sure you fit them. The program is called the Discriminant Inventory Function System (DIF), and it assigns a numeric score to each individual tax return after it's been processed. If your score varies wildly from the norm, chances are, you'll be flagged.

The bottom line: Be smart. But don't cheat yourself, either. Don't let a fear of being audited discourage you from reporting unusual losses or significant itemized deductions that you may be entitled to. Just be sure to keep good records to substantiate those items.

It is true that your chances of being audited are increasing. As the numbers of audits go up, take steps to protect yourself. Don't be greedy, keep good records, and check (and double-check) your return. The fewer reasons you give the IRS to take a second look at your return, the better.